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Rev. Dec. 6, 2019

Financial Analytics Toolkit: Ratio Analysis

Ratio analysis provides insight into the performance of a firm, and ratios are often used in forecasting
expected future performance. They summarize operating behaviors and results in ways that facilitate
interpretation and highlight decisions. There are three broad categories of ratios: profitability, operating
efficiency, and leverage (the use of debt financing). Most applications use line items directly from financial
statements, although a few also use a firm’s stock price. Many ratios link income statement amounts to balance
sheet amounts. When doing so, one typically uses the end-of-year balance sheet amount associated with a given
year’s income statement amount.

Profitability Ratios

Profitability ratios evaluate the degree to which operations are providing an acceptable return on
investment (ROI). The return can be evaluated relative to all investments (assets) or just to the investment
made by shareholders (equity). A common framework for discussing firm profitability is the so-called DuPont
decomposition. The elements of this framework are shown in Table 1.1
Table 1. DuPont decomposition.

Profit margin NI/Sales Measures operating efficiency: Describes how much income is
generated from a dollar’s worth of sales

Asset turnover Sales/TA Measures asset utilization: Describes how much revenue is generated
from a dollar’s worth of assets

Leverage TA/OE Measures the use of debt financing: Describes how much is invested
in assets for each dollar’s worth of equity investment

Return on assets (ROA) NI/TA The rate of return generated by invested assets

Return on equity (ROE) NI/OE The rate of return earned by equity investors
Source: All tables created by author.

In addition to the insights provided by each measure, there is a link between these that is often emphasized.
Specifically, that:
1 We will employ the following common abbreviations: NI = net income; TA = total assets; OE = owner’s equity (the sum of all equity accounts);

COGS = cost of goods sold; CA = current assets; CL = current liabilities; INV = inventory; AR (or A/R) = accounts receivable; AP (or A/P) = accounts
payable; EBIT = earnings before interest and taxes (also called operating income); t = the tax rate on taxable income.

This technical note was prepared by Marc L. Lipson, Robert F. Vandell Professor of Business Administration and Editor in Chief of Financial Management.
Copyright © 2019 by the University of Virginia Darden School Foundation, Charlottesville, VA. All rights reserved. To order copies, send an email to
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ROA = Profit margin × Asset turnover

ROE = Profit margin × Asset turnover × Leverage = ROA × Leverage
In this way, we see that the return earned on assets is a function of (the product of) operating efficiency
and asset utilization, and that the return to equity holders is the ROA scaled up by the degree to which debt
financing is used.2
Whenever an ROI is calculated, it is important to distinguish between book values and market values. Book
values, taken from the financial statements, reflect past actions. For example, the book value of total assets is
equal to the sum of the amounts paid when the asset was acquired less the depreciation taken over time.
Similarly, the equity accounts reflect the proceeds received from equity financings at the time the financing
occurred along with the earnings retained at the time they were earned. The current value of either assets or
equity is likely to have changed substantially. A return should reflect what is obtained relative to the current
value of an investment, not its historic value, although this is not always implemented. In particular, the inputs
to the DuPont decomposition are often obtained from financial statements and are, therefore, book values.
However, this analysis can still provide insight into changes over time and may allow comparisons across firms.
In addition to the measures above, there are a number of other common measures focused on earnings
and dividends. These are all scaled in order to describe either the amount obtained per share or the return
obtained per dollar. The most common are shown in Table 2.
Table 2. Common ratios based on earnings and dividends.

Earnings per share (EPS) NI/Shares The net income generated by the firm for each
share outstanding

Dividend per share Total dividend/Shares The dividend paid to each share outstanding

Earnings yield EPS/Price The net income per share provide by the firm
for each dollar of share value

Dividend yield Dividend per share/Price The return provided to shareholders that they
receive through a dividend

Price–earnings ratio Price/EPS The magnitude of the current price relative to

the current earnings of a firm

There is one common measure used to capture the ability of a firm to create value from its investments. If
we consider the current market value of the firm (the sum of equity value and debt value) to reflect the total
value created by firm actions, and we consider the book value of the firm to reflect the total amount invested,
then the so-called market-to-book ratio reflects the value created for each dollar of investment:

Market-to-book ratio (Price × Shares + Debt) / (OE + The ratio of the market value of equity (price
Debt) per share multiplied by shares outstanding)
plus the book value of debt to the book
value of equity and debt

2 The measure of leverage used in a DuPont decomposition is not the most common such measure. However, when this specific form is multiplied

by ROA, the result is ROE.

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This ratio assumes, as is reasonable in most cases and commonly done, that the book value of debt is a good
estimate of the market value of debt.

Operating Efficiency Ratios

Firms engage in a variety of operating activities, which span the provision of a good or service that is sold
through the management of investments needed to sustain the provision of those goods and services. A wide
variety of operating ratios are used to evaluate those activities. The most commonly employed are shown in
Table 3.
Table 3. Common operating efficiency ratios.

Operating Profitability

Gross margin (%) (Sales − COGS) / Sales The amount a firm earns above the cost of the
goods it has sold, as a percentage of the selling
price

Operating margin (%) Operating income / Sales The amount the firm earns above all costs except
financing costs and taxes, as a percentage of the
selling price

Liquidity

Current ratio CA / CL The ratio of short-term assets (those turning to

cash within a year) to short-term liabilities (those
due to be paid within a year)

Quick ratio (Cash + AR) / CL The ratio of the most liquid short-term assets to
short-term liabilities

Activity

Days inventory INV / (COGS / 365) Average number of days between the day
inventory is purchased (or manufactured) and
when it is sold

Inventory turnover COGS / INV Average times inventory is fully replaced (turned
over) in a year

Days receivable AR / (Sales / 365) Average number of days between the day a sale is
made and when the cash is received; also called
days sales outstanding

Days payable AP / (COGS / 365) Average number of days between the day
inventory is received and when the payment for
that inventory has been made
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The operating profitability ratios describe the cost structure of the firm. They emphasize the relation
between prices and inputs, and are used to evaluate operating efficiency. The liquidity ratios describe the ability
of the firm to meet its payment obligations related to short-term commitments, specifically the ability to make
payments related to current liabilities. The activity ratios describe the way a firm is managing its balance sheet.
They show how quickly cash is received or paid, how long inventory is kept on hand, and how well the firm is
limiting its asset investments relative to the scale of its operations (asset utilization).

At this point, it is worth commenting on how ratios are traditionally expressed. While some are the
underlying ratio without modification, others are expressed as percentages, and some are scaled so as to reflect
a number of days.3 Ratios described as turnovers are sometimes appended with the word “times” or “×” to
emphasize the scaling, such as in the statement “sales are three times assets.” In fact, inventory is just as
commonly expressed as a turnover or in days, and both variants are listed above. The default choice is made to
ease interpretation. Days receivables, for example, describes the number of days it takes (on average) for a sale
to be received as cash, and can be compared to a firm’s credit terms (customers may be given 30 days to make
payment after a purchase). In general, a percentage is used to avoid decimals, and days is used when there is a
clearly meaningful time element.

Leverage Ratios

How a firm chooses to finance its operations can dramatically affect performance. For example, the use of
debt financing will have a large impact on the ROE (as seen in the DuPont decomposition), and both interest
payments and principal repayments are an inflexible drain on operating cash flows. A wide variety of ratios are
used to describe a firm’s financial choices. Since the degree to which a firm uses debt is often referred to as
“financial leverage,” or simply “leverage” when the context is clear, the financing-related ratios are referred to
as leverage ratios. All leverage ratios measure, in some fashion, the use of debt and the burden of debt payments.
The most common ratios are shown in Table 4.
Table 4. Common leverage ratios.

Times interest earned EBIT/Interest The ability of a firm to meet its required interest
payments from pretax operating cash flow

Debt service coverage EBIT/Total debt service The ability of a firm to meet all its required debt
payments from pretax operating cash flow

Debt ratio Debt/TA The magnitude of debt relative to the total assets of
a firm; also called the debt-to-assets ratio

Debt-to-equity ratio Debt/OE The magnitude of debt relative to the use of equity
financing

Leverage ratios are often adjusted to suit various applications, and many variants exist. This can be a source
of frustration and confusion. For example, the leverage ratio used in a DuPont decomposition is the inverse of
the more common debt ratio. The debt ratio itself may have many forms. Sometimes, for example, debt may
be limited to long-term debt. Furthermore, debt plus equity will not equal total assets due to the existence of

3 In addition, some ratios scale variables with sales and some with COGS. The choice is made to better capture the underlying meaning of the ratio.

Accounts receivable are recorded at the sales price, whereas inventory is recorded at its cost. Thus, to calculate a meaningful representation in terms of
days, days receivables is calculated from the relation between accounts receivable and sales, while days inventory is calculated from the relation between
inventory and COGS.
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operating liabilities. For this reason, some calculations will use the sum of debt and equity for total assets in the
debt ratio, and some calculations will assume debt is equal to total assets less equity (essentially including
operating liabilities in debt). Finally, in some instances, the amount of cash on hand will be subtracted from
debt (the result is referred to as “net debt”). Since these many variants can lead to slightly different conclusions,
leverage ratios require extra care and attention.

Interpretation and Use of Ratios

Ratios are a powerful tool for generating insight into a firm’s performance. However, they should be
interpreted with care. It is tempting to think of ratios as having an inherent “direction” that is “good.” For
example, that a high inventory turnover (low days inventory) is preferred. In some sense, holding the activity
level of the firm constant makes sense. However, if inventory levels are kept too low, it may result in lost sales.
A good approach to interpreting ratios is to think of them as having an optimal range. They can also be readily
used as targets or goals. When possible, one should have data to contextualize the ratios: a time series of past
ratios, typical industry benchmarks, and/or relevant firm policies and objectives.

It is also vital to keep in mind, as illustrated in the DuPont decomposition, that many ratios are related,
that they interact, and that they can offset each other. Consider these examples: an increase in certain types of
assets (lower asset turnover) could allow the firm to borrow more than they otherwise could borrow (increased
leverage); a company may stock more inventory (lower inventory turnover) if it obtains favorable financing
terms (increased days payables); and an increase in cash is inefficient (lower asset turnover) but will provide an
enhanced ability to meet unforeseen payments (increased liquidity).

Ratios are also commonly used to generate financial forecasts. In such applications, a ratio is first assumed,
and the resulting financial statement line item calculated. For example, if sales have been estimated for a given
year and a firm targets an inventory level in terms of inventory turnover, then the expected level of inventory
can be calculated. In general, financial forecasts start with an assumption regarding sales (or sales growth), and
the ratios are used to build the income statement and balance sheet. Of course, some accounts do not lend
themselves to ratio forecasting and are better forecast from accounting rules. This ensures that the financial
statements are internally consistent. For example, the balance in the equity account should equal the prior year’s
balance, plus net income, less any dividend. Similarly, the balance in the long-term asset accounts should equal
the prior year’s balance, plus capital expenditures, less depreciation.

In most instances, the simplest versions of ratios provided above are used. These simple versions will show
changes over time, can be used for comparisons, and will facilitate forecasting. The key is to be consistent and
use the same calculations. In some contexts, however, ratios need to be closer in magnitude to their intended
meaning and more complex versions are used. Consider these common variations:
• Days inventory can be calculated with the average inventory over a year rather than ending inventory
since COGS occur over the year. The result would be a more accurate measure of the time inventory
was kept on hand. A similar argument could be made for receivables and payables ratios.
• Days receivables can be calculated using only credit sales if the actual time it takes to collect noncash
sales is of interest.
• Current ratios are sometimes calculated directly from the reported current assets and current liabilities,
but sometimes they are calculated excluding financial accounts such as short-term debt. The operating
version emphasizes how assets will turn to cash, and will help meet obligations without any action
taken by the firm to provide financing. On the other hand, if the payment of financial obligations is of
concern, the debt accounts should be included.
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In the vast majority of contexts, the simplest versions of the ratios are sufficient, and one can generally
assume the simplest version was calculated.

Application

Exhibit 1 presents the Income Statement and Balance Sheet for two years for Morgan Industries (Morgan),
a hypothetical firm, including some additional information related to the equity accounts. Exhibit 2 presents
the ratios derived from that information. Note that ratios that rely on a stock price are only calculated for the
most recent year, the year a stock price is provided. Also, the debt service coverage ratio is omitted since no
information on required debt payments is provided.

A few observations can be made from these ratios. Morgan has quite definitely improved its operating
efficiency, largely due to a 1% reduction in COGS. This carries through to an improvement in ROA and ROE
despite a slight decline in asset turnover and leverage. We also see that due to a 3.49× asset turnover, the
efficiency improvement dramatically improves ROA; and due to a 2.15× leverage ratio, the ROA improvement
is further magnified. The result is a jump in ROE from just above 16% to almost 20%. Given the cost savings,
EPS has jumped, and Morgan has decided to increase its dividend from $1.20 a share to $1.50 a share. The
most recent dividend yield is about 3%—so equity investors are getting a 3% return on their investment paid
to them in cash.

As for asset management, we see an increase in days inventory (reduction in turnover) and days receivables.
This suggests a reduction in asset utilization. This reduction, however, is offset by an increase in days payables
and an increase in the bank loan. The net change in current assets and liabilities is such that the current ratio
and quick ratio are slightly reduced.

The decrease in liquidity might raise concerns about Morgan’s ability to pay its interest payments. Since the
debt levels have changed only slightly (interest payments increased by a small amount) while operations have
increased in scale and profitability, we see a dramatic improvement in times interest earned. Furthermore, the
increase in firm size has reduced the relative magnitude of debt.4 Thus it appears Morgan is in no danger of
missing interest payments.

All told, one justifiable conclusion from the ratios is that Morgan has made significant operating
improvements, although the firm might focus some effort on managing short-term assets.

4 Note that the table includes two different versions of the debt ratio. The calculation for each version is indicated.
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Exhibit 1
Financial Analytics Toolkit: Financial Ratio
Financial Statements of Morgan Industries
(all amounts are in millions, except share price)

Prior Recent
Income Statement
Sales 2,713 2,844
Cost of goods sold 1,721 1,768
992 1,076
Operating expenses 913 964
79 112
Interest expense 10 12
69 100
Tax 17 25
Net income 52 75

Balance Sheet
Cash 62 74
Accounts receivable 85 103
Inventory 158 181
305 358
Property and equipment 403 458
708 816

Accounts payable 123 156

Other accrued expenses 41 48
Bank loan 24 32
188 236

Bonds outstanding 200 200

Common stock 125 125
Retained earnings 195 255
708 816
Supplemental Information
Total dividends paid 12 15
Depreciation 58 62
Shares outstanding 10 10
Price at year end 55.00

Source: Created by author.

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Exhibit 2
Financial Analytics Toolkit: Financial Ratio
Ratio Analysis of Morgan Industries

Prior Recent
DuPont Decomposition
Net margin 1.91% 2.64%
Asset turnover 3.83 3.49
Leverage 2.21 2.15
Return on assets 7.31% 9.19%
Return on equity 16.17% 19.74%

Profitability
Earnings per share $5.18 $7.50
Dividend per share $1.20 $1.50
Earnings yield 13.64%
Dividend yield 2.73%
Price–earnings ratio 7.33
Market-to-book ratio 1.28

Operating Efficiency and Asset Utilization

Gross margin 36.56% 37.83%
Operating margin 2.91% 3.94%
Days inventory 33.51 37.37
Inventory turnover 10.89 9.77
Days receivables 11.44 13.22
Days payables 26.09 32.21

Liquidity
Current ratio 1.62 1.52
Quick ratio 0.78 0.75

Leverage
Times interest earned 7.90 9.33
Debt ratio [debt / total assets] 0.32 0.28
Debt ratio [debt / (debt + equity)] 0.41 0.38
Debt-to-equity ratio 0.70 0.61
Source: Created by author.